2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Modified holdings, January 2014

February 5, 2014

The Vanguard Total World Stock ETF (VT) replaces the Vanguard FTSE Emerging Markets ETF (VWO) in the SmallTrades ETF Portfolio.  The revised portfolio will be rebalanced as needed to correct a 28% error in asset allocation. 

Rationale

The investment performance of VWO is declining due to unfavorable conditions in the emerging markets.  Political turmoil and fragile economies in several regions of the emerging markets account for declining global productivity (1,2,3).  The impact on financial markets is shown by a slight downtrend in emerging markets stock indices compared to an upsurge in developed markets stock indices (chart 1, ref 4).

chart 1.  Line graphs represent 3 series of cumulative returns from an investment of $1 (USD) in 2003.  The cumulative returns of the All-World Markets, Developed Markets, and Emerging Markets were computed from the total annual returns of the FTSE Global Equity Index Series.   The All-World Markets were comprised of Developed Markets (approximately 75% weighting) and Emerging Markets (approximately 25% weighting).  Frontier Markets were excluded.

chart 1. Line graphs represent 3 series of cumulative returns from an investment of $1 (USD) in 2003. The cumulative returns of the All-World Markets, Developed Markets, and Emerging Markets were computed from the total annual returns of the FTSE Global Equity Index Series. The All-World Markets were comprised of Developed Markets (approximately 75% weighting) and Emerging Markets (approximately 25% weighting). Frontier Markets were excluded.

The investment strategy of VWO is to track the FTSE Emerging Markets index while VT seeks to track the FTSE All-World Markets index.  Chart 2 (below) is similar to Chart 1 in showing that VWO’s market prices are gradually declining while VT’s prices are steadily climbing.

chart 2

chart 2

The replacement of VWO by VT in the SmallTrades ETF Portfolio will satisfy the risk-management strategy of diversification.  The revised Portfolio might outperform the benchmark S&P 500 total return index under favorable market conditions in years to come.  Here are several lines of supportive evidence:

1)      A hybrid stocks index of U.S. large-capitalization stocks (75% weighting) and emerging market stocks (25% weighting) yielded an annualized return of 6.1% compared to an 5.7% annualized return from the benchmark U.S. large-capitalization stocks.  The time period was 1997-2011.

2)      A model portfolio of the hybrid stocks, U.S. bonds, U.S. REITs, and precious metals indices yielded an annualized return of 8.5% compared to the benchmark 5.7% return.   Equal amounts were invested in every index at the beginning of the 1997-2011 holding period.

3)      VT tracks the FTSE Global All-Cap index.

4)      Charts 3 and 4 ( below) summarize the 5 year performance of the revised SmallTrades ETF Portfolio as determined by an updated ETFportfolioDESIGNER2.  The best rebalancing strategy is to correct a 28% “rebalance signal”.

chart 3

chart 3

chart 4

chart 4

Portfolio Mechanics

The SmallTrades ETF Portfolio is modified by substituting VT for VWO without changing the original allocation plan.  Twenty five percent of the portfolio’s market value is allocated to four asset classes represented by VT, VNQ, AGG, and the combined GLD-SGOL holdings –[comment: GLD and SGOL are operationally equivalent except that they store gold bullion in different vaults located in London and Zurich.  The split vaults help protect from physical damage and theft in one vault]–.  The Portfolio will be rebalanced when any asset class deviates outside the 72-128% range of expected market values.

References

1.           Emerging markets, Locus of extremity.  Developing economies struggle to cope with a new world. The Economist.  2/1/2014

2.           Paul Wiseman and Joshua Freed.  Markets staggered by global concerns. Associated Press. 1/25/2014.

3.           Emerging economies; When giants slow down. The Economist  7/27/2013.

4.           FTSE Factsheet.  12/31/2013.


Design of the investable ETF portfolio

August 28, 2013

[revised on September 3, 2013 and February 3, 2014.  The latest revision is an updated ETFportfolioDESIGNER2 that includes Vanguard’s Total World Stock ETF (VT).  It was necessary to reset the DESIGNER’s time period to 2009 through 2013.  Appropriate changes were made in the following discussion.]

Summary

I ‘like’ a portfolio of exchange traded funds (ETFs) that are listed in the New York Stock Exchange by trading symbols AGG, GLD, VNQ, and VWO [VT is an alternative to VWO]. Equal portions of capital are allocated to each fund. The best way to manage the portfolio is by rebalancing the ETFs. Ordinary investors can be cautiously optimistic about this high risk portfolio after reviewing the following information:

Model

Among previously tested portfolios, a 4-sector model held hypothetical investments in market indices for emerging markets stocks, U.S. bonds, U.S. REITs, and global precious metals.  The model was not an investable portfolio.

Conversion

The 4-sector model was converted to an investable portfolio by substituting index ETFs for the market indices and assigning equal weightings (ref 1) to the ETFs. The big advantage of choosing index ETFs is their ease of trading in the stock market (ref 2).  The objective of the investable portfolio, hereafter called the SmallTradesETFportfolio, is to outperform the U.S. stock market in the long term.

The conversion began by screening funds according to geography and asset class (ref 3).  Selected ETFs were compared to their financial markets, appraised for risk, and tested for optimal portfolio mechanics.

Comparisons.  Chart 1 shows the time course of total returns from ETFs and financial markets. The total returns are charted as monthly percentages of change in market value based on price changes and cash distributions (see endnote) .

ETFpf1

Chart 1. Time course of total returns: All panels show the time course of monthly total returns from a market sector (black dashed line), older ETF (solid blue line), and newer ETF (solid orange line). ETFs are identified by 3-letter trading symbols. Total returns were set to 0% at inception of the newer ETF.

In chart 1, any spread between an ETF and its market sector illustrates the difference in investment performance. Smaller spreads, and therefore closer matches to sector performance, occurred among ETFs aligned to the precious metals and emerging markets stock sectors. Wider spreads appeared when AGG outperformed the U.S. Bond sector by 3-15 percentage points during the 2008 Credit crisis; also when VNQ and REZ consistently underperformed the Equity REIT sector by an average 8 percentage points.

Correlations. Chart 2 shows the correlation of returns between an ETF and its market index.

ETFpf2

Chart 2, Correlation of total returns: ETFs are identified by 3-letter trading symbols. All panels compare the monthly returns of ETFs to their corresponding market sector. Monthly returns were calculated as a percentage change in market value that includes the accumulation of cash distributions from underlying holdings. The identity line shows hypothetically equal returns. “r” values are correlation coefficients for the relationship between ETF and sector returns. “r” values were not calculated for newest funds, CORP and GLTR, due to the scarcity of monthly returns.

In chart 2, the correlation coefficient (“r”) signifies the degree of alignment between concurrent monthly returns. If r were 1.0, the data would lie on an identity line where fund returns match the market returns. All r values in chart 2 were exceptionally high, which supports the visual impression from chart 1 that ETFs traced the time course of their market sectors. All of chart 2’s data except those for AGG were closely aligned to an identity line. About 12 of AGG’s monthly returns outperformed the U.S. Bond market during the 2008 Credit crisis and appear as outliers to their line of identity. The few outliers exerted no practical effect on AGG’s correlation coefficient.

ETF appraisals. The SmallTradesETFportfolio contains healthy, wealthy ETFs with proven ease of trading. Every ETF is eligible for holding in a tax-deferred brokerage account and otherwise offers a low tax burden when held in a taxable account (exception: returns from the precious metal held by GLD are taxed at the higher rate for ordinary income rather than lower rate for long-term capital gains). Here are the investment strategies and risks of the funds, with a link to their scorecards (ref 4):

  • AGG (iShares Core Total U.S. Bond Market ETF) invests 95% of its capital in a basket of U.S. investment grade bonds that reflect the Barclays Capital U.S. Aggregate Bond Index. AGG receives fixed income and capital gains from the bonds. The fixed income is derived from payments of interest and returns of principal. Investment grade bonds are less likely to default on payments of fixed income than non-investment grade (‘junk’) bonds. Investment grade bonds generally pay lower interest than junk bonds and are low-risk investments (ref 5).
  • VWO (Vanguard FTSE Emerging Markets ETF) invests 95% of its capital in a representative sample of stocks listed in the FTSE Emerging Markets Index. Emerging markets stocks are more volatile and less liquid than U.S. stocks. Stocks are generally high-risk investments that reward investors with payments of dividends and capital gains. VWO invests in emerging market stocks which have characteristically higher risk and higher returns than developed market stocks (ref 5).
  • VT (Vanguard Total World Stock ETF) invests in stocks issued in the emerging and developed markets.  VT is an alternative to VWO.
  • VNQ (Vanguard REIT ETF) invests in real estate properties by purchasing shares of real estate investment trusts (REITs). Equity REITs are companies who invest pooled money into the ownership of real estate and distribute at least 90% of their taxable income to shareholders. Equity REITs are considered low-risk, high-return investments (ref 5). Because VNQ concentrates on real estate, its primary risk is a decline in the real estate market.
  • GLD (SPDR Gold Trust) is a physical commodity fund that invests all capital in gold bullion. Gold only provides income when sold in the market for a profit. Investors typically buy gold bullion as an insurance policy against the devaluation of currency (ref 5). GLD shareholders risk losses from declining prices and damage or theft of the bullion.

Portfolio mechanics

Market forces continually change the value of a portfolio either to the benefit or detriment of the investor. The investor’s choices are to make no adjustments (“buy-and-hold”), sell rising assets to buy declining assets (“rebalance”), sell declining assets to buy rising assets (“reallocation”), or revise the investment strategy (ref 6).

The choices to buy-and-hold or rebalance the SmallTradesETFportfolio were examined by using a computer-assisted program to test a set of 5-year historical returns from the ETFs [the computer-assisted program is outdated and therefore replaced by ETFportfolioDESIGNER2.  The discussions of Tables 1 and 2 are outdated, but they remain instructive]. The buy-and-hold strategy was to purchase each ETF with 25% of the total invested money and automatically reinvest the cash distributions. The rebalance strategy was divided into 2 plans for correcting the buy-and-hold portfolio.  The scheduled plan made regular corrections during the life of the portfolio. The signaled plan made irregular corrections depending on when the holdings drifted from the allocation plan by an assigned error signal (ref 7).

The data in table 1 show that all choices outperformed the benchmark investment in U.S. stocks.  Both rebalancing plans enhanced the portfolio CAGR of the buy-and-hold strategy, namely by 1.3 percentage points when rebalanced yearly and by 2 percentage points when rebalancing a 32% allocation error.

ETFpf3

COLUMN HEADINGS: The investment strategies for the ETF Portfolio are “Buy-and-hold”, “Rebalance #1”, and “Rebalance #2”. The “Benchmark” portfolio is an index of the U.S. Stock Market.
ROW HEADINGS: “Rebalancing plan” shows the best schedule for “Rebalance #1” and best error signal for “Rebalance #2”. “Rebalance episodes” are the total number of rebalances. “Final market value” is computed from the weighted market returns. “Portfolio CAGR” is the compound annual growth rate; higher CAGRs reflect higher returns. “Sharpe ratio” is an adjusted annual rate of return; higher ratios reflect higher returns.
ASSUMPTIONS: Every portfolio is funded with $10,000 and 25% of the $10,000 is allocated to each holding. There are no fees for financial services, all cash distributions are automatically reinvested, and the portfolio holdings are never withdrawn.

Efficient investment. The total returns in table 1 were earned under the best of circumstances because there was no payment of fees for financial services and plenty of money was used for making the initial investment. Without fees, all levels of initial investment are equally efficient in yielding a return. But additional fees create a penalty margin that reduces returns by as much as 25 percentage points with $1,000 investments and 2 percentage points with $10,000 investments (ref 8).

So, how might trading fees and initial investment affect the SmallTradesETFportfolio? Table 2 demonstrates the efficiency of earning returns based on the initial investment and a $10 trading fee.

ETFpf4

The data are total returns as measured by CAGR; higher CAGRs reflect higher returns. All trading fees are $10/trade.
ROW HEADINGS: “Initial investment” is the total amount of money spent on creating the portfolio, including trading fees. “Buy-and-hold” means that no trading occurred during the 5-year holding period, 2008-2012. “Rebalance #1” is a plan to rebalance the holdings on an annual basis. “Rebalance #2” is a plan to rebalance the portfolio when a holding drifts from the allocation plan by a 32% difference.

In table 2, the maximal returns of the buy-and-hold and rebalanced portfolios were achieved when the initial investment reached $15,000. There was no advantage to rebalancing the portfolio with only $2,000 of invested capital.

Financial services fees. ETF managers charge an annual expense ratio to specialists in the primary market, not to ordinary investors in the secondary market.  The expense ratio reduces the net asset value of ETF shares in the primary market and the net asset value determines ETF share prices in the stock market (ref 2). Ordinary investors may pay an advisor’s fee when they are clients of a financial institution (do-it-yourself investors take pride in avoiding this fee). The typical advisory fee, about 1% of the annual portfolio value, reduces the total return of the portfolio by an amount that can be estimated in the computer-assisted program.

Recommendation

The SmallTradesETF Portfolio is designed for risk-tolerant investors who seek to outperform the U.S. Stock Market over a time period of many years. Each ETF tracks a unique sector of the financial markets with proven transparency, durability, and liquidity of fund operations. In terms of risk management, rebalancing the holdings helps protect from losses incurred during market declines. An initial investment of $4,000 is needed to gain the advantage of rebalancing the portfolio. Better results are obtained by investing at least $10,000.   I prefer using a 30% 28% rebalancing signal (rather than a schedule) to rebalance the SmallTradesETFportfolio. The signaled rebalancing method is easy to obtain and use by clicking on this link, Rebalancing an Investment Portfolio.

Cautious optimism

Similar portfolios are advocated in newspapers (ref 9) and books (refs 10-12). The unique features of the SmallTradesETF portfolio are its simple allocation plan and tested rebalancing strategy. A major disadvantage is the uncertainty about future market returns. Fifteen years of historical data for a model portfolio and 5 years of historical data for an ETF portfolio are unreliably predictive of future returns (ref 10). Consider that ¼th of the Portfolio is invested in emerging markets stocks and that today’s emerging markets are in decline after attaining a historical peak (refs 13,14). How long will these markets decline? The optimist could argue that over 75% of the world’s population lives in the emerging economies where there’s tremendous capacity for growth. Today’s emerging economies have nearly half of the world’s GDP and their share of the global GDP seems to be growing despite blips in the trajectory  (ref 14).

Endnote:  Cash distributions are made by fund managers to fund shareholders. The typical sources of cash distributions are dividends and capital gains earned from the fund’s underlying assets.

Copyright © 2014 Douglas R. Knight

References

1. Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing, U.S. Securities and Exchange Commission, SEC.gov/investor/pubs/assetallocation, Modified: 08/28/2009.
2. ETF structure, Small Trades Journal, a blog at WordPress.com.
3. XTF, ETF experts. XTF.com/Research/.
4. #ETF-scorecard, Small Trades Journal, a blog at WordPress.com.
5. Asset classes, Small Trades Journal, a blog at WordPress.com.
6. Jason Van Bergen, 6 Asset Allocation Strategies That Work. ©2013, Investopedia US, A Division of ValueClick, Inc., October 16, 2009.
7. #SmallTradesPortfolioREBALANCER, Small Trades Journal, a blog at WordPress.com.
8. Beware of trading fees, Small Trades Journal, a blog at WordPress.com.
9. Anna Prior. A Portfolio That’s as 2-sector as One, Two, Three. The Wall Street Journal, July 7, 2013.
10. William Bernstein. The Four Pillars of Investing: Lessons for Building a Winning Portfolio, McGraw-Hill, 2002.
11. Mebane T. Faber and Eric W. Richardson. Top of the Class: A review of The Ivy Portfolio. 4/6/2009, Advisor Perspectives, DShort.com.
12. John C. Bogle, The Little Book of Common Sense Investing. John Wiley & Sons, Inc. Hoboken, 2007.
13. Emerging economies: When giants slow down. Jul 27th 2013. The Economist.
14. Emerging vs developed economies: Power shift. Aug 4th 2011, 17:34 by The Economist online.


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